BUDGET AUTO COMPONENTS LTD. Sandy Kaur is a recent graduate who completed her master's degree in professional accountancy. Upon completing her master's degree, Sandy took up a job at Budget Auto Components Ltd (BAC). BAC is a relatively small supplier of selected vehicle parts to large automobile and truck manufacturers. BAC competed on a price basis with large suppliers that were long established in the market. BAC had competed successfully in the past by focusing on parts that, relative to the industry, were of small volume and hence did not permit BAC's competitors to take advantage of economies of scale. For example, BAC produce certain parts required only by "off-the-road" equipment such as front loaders. As her first project on the job, BAC's Chief Executive officer (CEO) asked Sandy to review the company's present cost accounting procedures. In outlining this project to Sandy, the CEO had expressed three concerns about the present cost accounting system: (1) its adequacy for purposes of cost control, (2) its accuracy in arriving at the true cost of products, and (3) its usefulness in providing data to judge the supervisor's performance. Sandy began the cost accounting study in BAC's carburetor and fuel injector (CFI) division, which accounted for about 50% of BAC's sales. This division contained five production departments: Casting and stamping, Grinding, Machining, Custom Work, and Assembly. The casting and stamping department produced cases, valves, and certain other auto parts. The grinding department prepared these parts for further machining. The machining department performed all necessary machining operations on standard products, whereas the custom work department performed part of the machining and certain other highly specialised operations on custom products. The assembly department assembled and tested all products, both standard and custom. Thus, custom products passed through all five departments and standard products passed through all departments except Custom Work department. Spare parts produced for inventory went through only the first three departments. Both standard and custom products were produced to order; there were no inventories of completed carburetors or fuel injectors. Sandy's study revealed that except for materials cost, all product costing was done based on a single plant-wide direct labour hourly rate. This rate included both direct labour and factory overhead costs. Each batch of products was assigned its labour and overhead cost by having workers charge their time to the job number assigned to the batch and then multiplying the total hours charged to the job by the hourly rate. Exhibit 1 shows how the July hourly rate was calculated. It seemed to Sandy that because the average labour skill varied from department to department, each department should have its own hourly costing rate. With this approach, time would be charged to each batch by the department; then the hours charged by the department would be multiplied by that department's costing rate to arrive at a departmental labour and overhead cost for the batch; and finally, these departmental labour and overhead costs would be added (along with the materials cost) to obtain the full cost of a batch. Sandy decided to see what impact this approach would have on product costs. The division accountant pointed out to Sandy that labour hours and payroll costs were already traceable to departments. Also, some overhead items, such as department supervisor's salary and equipment depreciation, could be charged directly to the relevant department. However, many other overheads including water, electricity, property taxes, and insurance, would need to be

Page 2 of 5 allocated to each department if the new approach were implemented. Accordingly, Sandy determined a reasonable allocation basis for each of these costs and used these bases to recast July's costs on a departmental basis. Sandy then calculated hourly rates for each department (shown in Exhibit 2). To obtain some concrete numbers to show the CEO, Sandy decided to apply the proposed approach to three CFI division activities: model BAC-29 fuel injectors (CFI's best-selling product), production of spare parts for inventory, and work done by the CFI division for other BAC's divisions. Exhibit 3 summarizes the hourly requirements of these activities by department. Sandy then costed these three activities using both the July plant-wide rate (existing method) and her proposed method of July departmental rates. Upon seeing Sandy's numbers, the CEO noted that there was a large difference in the indicated cost of BAC-29 injectors as calculated under the present and proposed methods. The present method was therefore probably leading to incorrect inferences about the profitability of each product, the CEO surmised. The CEO therefore was leaning toward adopting the new method, but told Sandy that the department supervisors should be consulted before any change was made. Sandy's explanation of the proposal to the supervisors prompted strong opposition from some of them. The supervisors of the BAC departments for which the CFI division did work each month felt it would be unfair to increase their costs by increasing charges from the CFI division. One of them stated: The CFI division handles our department's overflow machining work when we're at capacity. I can't control costs in the CFI division, but if they increase their charges, I'll never be able to meet my department's cost budget. They're already charging us more than we can do the work for in our own department, if we had enough capacity, and you're proposing to charge us still more! Also opposed was the production manager of the CFI division: I've got enough to do getting good quality output to our customers on time, without getting involved in more paperwork! What's more, my department supervisors haven't got time to become bookkeepers, either. We're already charging all the division's production costs to products and work for other departments; why do we need this extra complication? The company's sales manager also did not favour the proposal, telling Sandy: We already have trouble being competitive with the big companies in our industry. If we start playing games with our costing system, then will have to start changing our prices. You're new here, so perhaps you don't realise that we have to carry some low-profit or even loss items in order to sell the more profitable ones. As far as I'm concerned, if a product line is showing an adequate profit, I'm not hung up about cost variations among the items within the line. The strongest criticism of Sandy's proposed new system came from BAC's director of financial planning:

Page 3 of 5 Departmentalizing the costing rate may be a good idea, but I'm not sure you're attacking the main problem. How can we do anything with these cost estimates when you change the rates every month? When volume is rising, all our products make money, no matter which system you use. But when overall volume is falling some products begin to show losses even though their own sales continue to hold up. I don't know whether they are really losing money or whether they just can't carry a full share of the cost of idle capacity. I don't see how your system is going to help me answer that question. Faced with all these arguments, Sandy decided to make some more calculations before going back to the CEO. First, sandy asked the industrial engineering department to estimate the monthly volume at which the five production departments typically operated over the course of a year (normal volume). Then Sandy assembled a new set of overhead cost estimates and re calculated the proposed overhead rates, as shown in exhibit 4. Finally, Sandy recalculated the labour and overhead costs of 100-unit lot model of BAC-29 injectors and of a typical month's spare parts production, and work for other divisions, based on the "normalised" departmental rates. When Sandy circulated these new calculations, the production manager of the CFI division was even more concerned than before: That's even worse! Now you're piling up paperwork on paperwork! And on top of everything, we won't be able to charge out all our costs. What am I supposed to do with the costs in machining assembly if I can't charge them to products or spare parts for the work we do for other divisions? When Sandy reported the various managers opposition to the CEO, the CEO replied: You're not telling me anything that I haven't already heard from unsolicited phone calls from several supervisors for the last few days. I don't want to cram anything down their throats, but I'm still not satisfied our current system is adequate. Sandy, what do you think we should do? REQUIRED (1) Using data in the exhibits, determine the cost of a 100-unit batch of model BAC- 29, a month's spare parts, and a month's work done for other divisions under the present method, Sandy's first proposal, and her revised proposal. (2) Are the cost differences among the methods significant? What causes these differences? (3) Assume that producing a batch of 100 model BAC-29 injectors requires 126 hours, distributed by department as shown in Exhibit 3, and $4,200 worth of materials. BAC sells these carburetors for $115 each. Determine if this would be profitable at gross profit level? (Answer using both the present and Sandy's first proposed costing methods).

Page 4 of 5 (4) What benefits, if any, do you see to BAC if either of the proposed costing method is adopted? Consider this question from the standpoint of (a) product pricing, (b) cost control, (c) measuring departmental performance, and (d) diagnostic use of cost data. What do you think BAC should do regarding their costing procedures? (5) Are there any similarities between either of the proposed costing method and activity based costing? Justify your answers with appropriate explanations. Exhibits Exhibit 1: Calculation of plant-wide labour and overhead hourly rates for July Department Amount ($) Hours Labour Casting and stamping 54,604 2,528 Grinding 38,520 2,140 Machining 191,876 7,675 Custom work 81,664 3,712 Assembly 291,784 15,357 Total labour 658,448 31,412 Overheads 1,099,321 Total labour and overheads 1,757,769 Hourly rates $20.96 Overheads $35.00 Total $55.96 Exhibit 2: Proposed departmental labour and overhead hourly rates Department Per hour rates ($) Total Overheads Labour Overheads Total Casting and stamping 21.60 31.37 52.97 79,303 Grinding 18.00 30.14 48.14 64,500 Machining 25.00 62.52 87.52 479,841 Custom work 22.00 40.48 62.48 150,262 Assembly 19.00 21.19 40.19 325,415 1,099,321

Page 5 of 5 Exhibit 3: Direct labour-hour distribution for three CFI division activities Department BAC-29 Spare parts for inventory Work for other divisions (Hours per batch of 100 units) (Hours per typical month) (Hours per typical month) Casting and stamping 21 304 674 Grinding 12 270 540 Machining 58 1,115 2,158 Custom work - - - Assembly 35 - - 126 1,689 3,372 Exhibit 4: Departmental Overhead rates based on normal volume Department Normal volume (labour hours) Normal overhead cost* ($) Overhead per direct labour hour ($) Casting and stamping 2,500 78,800 31.52 Grinding 2,400 69,000 28.75 Machining 8,000 492,000 61.50 Custom work 3,600 147,820 41.06 Assembly 17,500 352,450 20.14 Total / Average 34,000 1,140,070 33.53 * Estimated overhead cost if each department operates at its normal volume